Optimal semi-static hedging in illiquid markets

TL;DR

This paper develops a method for indifference pricing of exotic derivatives using semi-static hedging strategies in illiquid markets, accounting for bid-ask spreads, and demonstrates its effectiveness through numerical examples on S&P500 options.

Contribution

It introduces a novel approach combining static and dynamic hedging in illiquid markets with bid-ask spreads, solved via convex optimization techniques.

Findings

Semi-static hedging significantly outperforms static-only strategies.

Indifference prices remain stable even with arbitrage opportunities or transaction costs.

Method successfully applied to path-dependent options on S&P500.

Abstract

We study indifference pricing of exotic derivatives by using hedging strategies that take static positions in quoted derivatives but trade the underlying and cash dynamically over time. We use real quotes that come with bid-ask spreads and finite quantities. Galerkin method and integration quadratures are used to approximate the hedging problem by a finite dimensional convex optimization problem which is solved by an interior point method. The techniques are extended also to situations where the underlying is subject to bid-ask spreads. As an illustration, we compute indifference prices of path-dependent options written on S&P500 index. Semi-static hedging improves considerably on the purely static options strategy as well as dynamic trading without options. The indifference prices make good economic sense even in the presence of arbitrage opportunities that are found when the underlying is assumed perfectly liquid. When transaction costs are introduced, the arbitrage opportunities vanish but the indifference prices remain almost unchanged.